It’s earnings season… that means that investors are waiting with bated breath to see what their favorite stocks have to report for the latest quarter. And Wall Street’s waiting to see how sentiment will push the broad market in the second half of 2010.

Looking at the financial media, you’d think that earnings season was the end-all be-all in the world of Wall Street – after all, a bad earnings release can make shares of some of the biggest companies fall double-digits.

However, it is important to keep these in perspective. Near-term earnings provide only a small part of the value of a company. The real value lies in a stock’s long-term earnings potential. Stocks are a long-duration asset, to use the Wall Street lingo.

The value of any stock is the sum of all future cash flows discounted to the present day. Of course, we can’t forecast such cash flows with accuracy, which makes valuing stocks an exercise in handicapping. Nonetheless, there are certain things we can say definitively about the source of value — namely, that near-term earnings make up a small portion of the value of a stock.

A study by James Montier, reprinted in his book Value Investing, affirms the truth of this idea. As Montier writes: “The first three years contribute a mere 10% to the total value. The next five years are slightly more important, representing some 15% of total value. However the long term proved far and away the greatest contribution to value, accounting for some 75% of the total.”

Graphically, here is the chart:

This is a great chart and one to sock away and remember. As much as investors fret over (or celebrate) near-term earnings, they are not very important to the intrinsic value of a stock. “This simple exercise,” Montier writes, “shows the relative unimportance of the next few years — even if they see earnings halve — to the long-term investor.”

Quarterly earnings reports can give us exciting (or disappointing) clues as to what’s going on. But we have to remember to consider the big picture. We have to consider whether what we are seeing is temporary or lasting. And we have to consider the price we pay for what we get.

So far, it seems companies are off to a good start. For instance, Alcoa (NYSE: AA), as The Wall Street Journal reported, “saw demand pick up in almost every one of its markets, suggesting possible improvements in the manufacturing sector as the world’s economy slowly recovers.” And Intel (NASDAQ: INTC) put up its best quarter in its 42-year history as computer sales recover.

We’ll see how some small-cap plays fare soon…

Sincerely,
Chris Mayer
Penny Sleuth

July 20, 2010

[Independence Note: Unlike scores of other penny stock resources, we’re 100% independent from the companies we talk about in the Sleuth – that means that we never accept compensation in exchange for profiling a company, and our editors never own a position in any stocks they talk about.]

Chris Mayer

Chris Mayer is managing editor of the Capital and Crisis and Mayer’s Special Situations newsletters. He also is a contributor to the Daily Reckoning. Graduating magna cum laude with a degree in finance and an MBA from the University of Maryland, he began his business career as a corporate banker. Mayer left the banking industry after ten years and signed on with Agora Financial. His book, Invest Like a Dealmaker, Secrets of a Former Banking Insider, documents his ability to analyze macro issues and micro investment opportunities to produce an exceptional long-term track record of winning ideas.

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